The Big Fail

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In 2009, Federal Reserve chairman Ben Bernanke told members of the Federal Crisis Inquiry Commission that regulatory reform would be a failure if it did not contemplate a system by which Goldman Sachs could go bankrupt and its creditors lose money.

While few would call banking regulatory reform a failure — thus far, at least — it has fallen well short of what Bernanke wanted. The “too-big-to-fail” problem, defined as the government using taxpayer dollars to rescue “systemically important” banks, remains unsolved. And the solutions being debated may elevate overall industry risk instead of subduing it.

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Taxpayer-funded bank rescues are political dynamite, of course, but in addition, the expectation of bailouts provides banks no incentive to guard against excessive risk. The recent history of ad-hoc crisis resolution — think Citigroup, Lehman Brothers, and General Motors — contributes to a climate of uncertainty. Major bank rescues can spark global economic upheaval, so it would help if everyone knew the game plan at the Treasury Department and the Federal Reserve before any future failures of large banks.

“Systemically important” banks are not going away. Banking regulators want their banks safe, sound, and big, says Ernie Patrikis, a partner in the bank and insurance regulatory practice of White & Case LLP. Many CFOs of multinational firms also see the money-center banks as indispensable for management, investment banking, and capital-raising. “They’re some of the best-run banks in the country,” says JoAnn Lilek, finance chief at consulting firm Accretive Solutions and former CFO of Midwest Bank Holdings. “They’re very well managed, they’re perceived to be very solid, and the breadth of services is incredible.”

Many CFOs think irresponsible management should suffer the consequences, but worry that, absent a government safety net, middle-market companies would be more vulnerable. While large corporations can just increase their stable of lenders, smaller companies have to concentrate their credit relationships with one or two banks to get access to debt, explains Lilek. In addition, many finance chiefs at midsize companies would not have the expertise or bandwidth to do the necessary credit monitoring that the removal of an implicit government backstop would require.

“If government bailouts were absolutely prohibited, I would be very concerned that [the problems of three years ago] would play out again and again,” says Ron Box, finance chief at Joe Money Machinery, a construction-equipment dealer. “It is a fact of life that we have a global financial system with very complex interrelated parts. Unfortunately, I do not believe that the clock can be turned back to a more isolationist time.”

Can U.S. banking regulators really solve — partially or in whole — the too-big-to-fail problem without exposing financial institutions to higher capital costs, subjecting nonfinancial companies (banks’ customers) to another credit crunch, or being granted an incredible amount of political independence?

You Say You Want a Resolution

After the demise of Lehman Brothers, letting the operating entities of big banks declare the kind of Chapter 11 in which they enter a turnaround situation or are acquired without government assistance seems unwise. And it is nearly impossible in the current regulatory framework, say restructuring experts. Allowing an insured bank to fail naturally shifts substantial risk back to the Feds. “What happens if someone takes those deposits guaranteed by the government and uses them up?” asks Jacen Dinoff, a principal at KCP Advisory Group. “You’re not going to see a bank file Chapter 11 and sit in bankruptcy winding down its assets while depositors petition as creditors to get percentage recoveries on life savings.”

The Dodd-Frank Wall Street Reform and Consumer Protection Act does limit how far regulators will go in propping up a large bank. The law grants the FDIC powers to dismantle the largest financial firms when they falter; the FDIC becomes a receiver for a bank if its failing presents a systemic risk to the financial markets. To help regulators devise plans to wind down huge banks, the biggest U.S. institutions — those with $50 billion in assets or greater — have to write “living wills.” The FDIC and the Federal Reserve were given 18 months to write a joint rule governing the drafting of living wills, so the rule could be unveiled later this year.

These bank-resolution blueprints might limit the amount the federal government would have to spend on bailouts, and they would also, to a degree, allow “market forces to creatively destruct an institution,” says Michael Hagedorn, CFO of UMB Financial, a $12 billion regional bank holding company. But the disposition of assets would need to be orderly, he says. For example, some of the largest banks in the United States perform securities processing for banks like UMB. “That couldn’t go away tomorrow and not have a big impact on the U.S. economy,” he says. “But you can sell that business to someone else, a much-better-run bank.”

But in the last financial crisis, Wall Street banks didn’t want to sell prized assets. “If they didn’t get a bailout, their next alternative would have been to sell off their good assets, but they didn’t want to do that, because they wanted the future revenue,” says Hagedorn. “If you let the free market function the way it is supposed to, it would dictate that they find a willing buyer and get the best price. When the government gets involved, it distorts this and lets a failed management team survive while allowing institutions with taxpayer-backed capital to actually grow their bank.”

Liquidation raises the specter of shotgun asset sales at a steep discount. Critics also contend that the speed with which the FDIC closes a community bank couldn’t be brought to bear at a larger institution. “I don’t think [resolution schemes] will work — because of the human factor, the panic that would set in,” says Sandy Brown, a partner at Bracewell & Giuliani LLP who served in the Office of the Comptroller of the Currency in the 1980s.

During the Latin American debt crisis, when major banks held sovereign debt that was trading at pennies on the dollar, U.S. regulators took a very measured approach, Brown says. They let the largest banks work out their problems over an extended period, rather than forcing them to recognize losses if they had to sell the debt immediately, he says. “In the next crisis, multiple institutions will experience problems simultaneously, and regulators need flexibility to work in a manner that is not terribly hasty.”

Keen to Intervene

Time is not something that regulators want to give failing banks in the next financial-market meltdown. Indeed, globally there is a concerted push to get national regulators to intervene sooner. Urs Rohner, vice chairman of the board at Credit Suisse, says regulators need much stronger powers to step in early. If a critical situation arises at a bank, said Rohner in a speech last spring, “authorities need the power to replace the senior management of the firm, order an increase in capital, order financial restructuring, and identify any parts of the firm that remain systemically vital and transfer those to third-party acquirers or, if necessary, to a bridge bank.”

“Regulators might want to step in and arrange marriages before the FDIC is called upon,” agrees Accretive Solutions’s Lilek. “Government could work to have transactions without FDIC assistance — if they mandated that the institution just needed more capital sooner,” she says. “The outcomes might reduce the costs to the FDIC insurance fund, which is a cost to the bank and ultimately a cost to the customer.”

Yet the early-intervention strategy is no panacea. It presents at least two problems, especially in the case of money-center banks:

First, spotting a bank that is headed for a catastrophic failure is not easy. Last fall, the Bank for International Settlements (BIS) released a study that showed how the consolidated financial reporting of international banks can easily hide developing trouble spots. Problems often originate on banks’ local-office balance sheets, says the BIS. To accurately measure a risk like short-term funding, for example, regulators would need data that breaks down a bank’s consolidated balance sheet into local offices. But no data exists with this level of detail, “or is likely to any time soon,” the BIS says.

Second, even if U.S. regulators do catch problems early, they may not have the resolve to take action. “The tool kit that [Dodd-Frank] gives regulators is pretty powerful,” says Bill Mutterperl, a partner at Reed Smith and former vice chairman of PNC Financial Services Group. “The question is whether they will have the prescience to recognize a systemically risky situation and whether they will have the political will to deal with it.”

Consider Continental Illinois National Bank and Trust Co. In 1981, it was the largest commercial and industrial lender in the United States. Three years later, it became the largest bank resolution in U.S. history (later surpassed by Washington Mutual). Problems at the $45 billion bank were evident at least two years before its demise, according to the FDIC study. Yet regulators failed to step in, leading to a capital infusion by the FDIC and an unlimited guarantee of all deposits. According to the FDIC paper, the will to dictate direction to the bank’s executive board was lacking.

Sharing the Load

Dodd-Frank at least ensures that taxpayers will no longer bear the full burden of federal rescues. Ideally, banks themselves — and their investors — will bear some or all of the losses. Rules published by the FDIC determine how creditors will be treated during the liquidation of a large financial institution. If regulators instill a sense of greater market discipline on investors, the hope is that investors will become better watchdogs of bank risk-taking.

Spreading future bank losses across the capital structure worries bank investors like Andrew Fraser, investment director in fixed income at UK-based Standard Life Investments. He says three aspects unnerve bank investors here and overseas. First, if government support is reduced in the future, the risk of senior bondholders sharing in any losses going forward rises, leading to bank bonds trading at wider spreads. Second, next-generation securities issued by banks will have more-complex structures, such as permanent-writedown language or conversion to equity when a bank’s capital breaches certain levels. “If bond investors are not comfortable with these new terms and conditions, funding from institutional investors could be more difficult to obtain,” Fraser says. And third, at least in Europe, more banks are turning to secured financing, like covered bonds. Covered bonds encumber more assets on the balance sheet, which could force lower recovery rates on unsecured bondholders.

However, changing the capital structure of banks so they can absorb larger losses is at least a partial remedy for bailouts. Contingent capital — debt that converts to equity when a systemically important institution heads into difficulties — provides an equity cushion in emergencies. It might not fit the investment mandates of investors in big-bank debt, like insurance companies, but this security type is starting to gain traction. In January, Rabobank issued a so-called CoCo, whose principal is written down if the bank’s equity-capital ratio falls below 8%. Similarly, a month later Credit Suisse sold debt that converts to equity if its core tier-1 capital ratio falls below 7%. In the United States, Dodd-Frank mandates that the Financial Stability Oversight Council produce a report on CoCos by mid-2012.

Some industry experts think banks simply need to hold more equity capital, above what Basel III requires. U.S. regulators are now determining the higher capital and liquidity levels that systemically important banks will have to meet. Anat Admati, a professor at Stanford University, suggests that 15% of non-risk-weighted assets would protect the financial system from recurring crises. Says CFO Lilek: “It would certainly be expensive to have that amount of capital, but it’s the right thing to do. Capital is there for the risks that you don’t know you have — the unforeseens.”

Too Far Gone?

None of the above measures would necessarily change the risky behaviors of large banks or forestall another global banking crisis. Nor would it preclude the United States from rushing to the aid of giant, crippled institutions. Put another way, the too-big-to-fail problem is still with us. Indeed, it could get bigger. Attorney Mutterperl notes that Dodd-Frank does not draw a line in the sand, as did Glass-Steagall, to prevent more banks from entering the too-big-to-fail fraternity. Banks got bigger when larger institutions merged with troubled banks during the financial crisis. Some regulators are now lobbying for an increase in the national deposit ceiling of 10%, but allowing banks to concentrate 15% or 20% of the country’s domestic deposits in one institution would create huge risks.

Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, believes that the Volcker Rule, which banned proprietary trading by banks, should have gone further and required financial institutions to carve out certain business lines. The existence of too-big-to-fail financial institutions “poses the greatest risk to the U.S. economy,” says Hoenig. Even if too-big-to-fail is framed not as a risk but as a promise, it would seem to be one that banking regulators can no longer afford to keep.